Lecture 3 - Chapter15 - Slides - Hai

MONEY AND BONDS
PREQUEL TO CHAPTER 15
Macro Fundamentals
THE ROLES OF MONEY

 The roles played by money (more broadly,
liquidity)
 Medium of exchange
 Eases double-coincidence of wants problem
 Unit of account
 A common “language” for all prices to be quoted in
 Store of value
 Apples will perish in short amount of time, dollar
bills won’t
2
Macro Fundamentals
THE ROLES OF MONEY

 How to conceptually “model” money a
surprisingly hard problem
 Much more difficult than, i.e., “consumption-

leisure framework” or “consumption-savings
framework”
 How to formally (mathematically) represent

these roles of money?
3
Macro Fundamentals
THE ROLES OF MONEY

 A shortcut: suppose money directly yields
utility
 Period-t utility function
 M t D
u  ct , 
 Pt 
 Money-in-the-utility-function (MIU)
formulation
 IMPORTANT: It’s not 𝑀𝑀𝐷𝐷𝑡𝑡 in the utility function,
but rather 𝑀𝑀𝐷𝐷𝑡𝑡/𝑃𝑃𝑃𝑃
4
Macro Fundamentals
REAL MONEY BALANCES

 Mt/Pt a key variable for macroeconomic analysis
 Unit Analysis (i.e., analyze algebraic units of

variables)
 Units(Mt) = $
 Units(Pt) = $/unit of consumption
 Units(Mt/Pt) =
$ unit of consumption
= $⋅
$ $
unit of consumption
= unit of consumption 5
Macro Fundamentals
REAL MONEY BALANCES

 Utility (composite of medium of exchange, unit of
account, store of value) depends on real money
(M/P), not nominal money (M)
 Measures the purchasing power of (nominal) money

holdings…
 …which is presumably what people most care about
 Mt and Pt can potentially grow at different rates

between periods
 In which case real money balances change from one

period to the next
6
Macro Fundamentals
MONEY MARKETS AND BOND MARKETS

 A prerequisite for analyzing monetary
policy: understanding bonds and bond
markets
 Bond markets and money markets tightly

linked to each other
 What is a “bond?”
 Simply put, a debt obligation (i.e., borrow
funds today, repay at some future date with
interest)
7
Macro Fundamentals

 …
 Types of bonds
Conventional  30-day, 60-day, 90-day Federal
monetary government bonds
policy
operates  1-year Federal government bonds
through short-
term bonds
 2-year Federal government bonds
8
Macro Fundamentals

 …
 Types of bonds
 …
 Foreign sovereign government bonds of various
maturities
 State and local government bonds of various
maturities
 Corporate bonds of various maturities
 Coupon bonds – pay something back (“coupon
payments”) every so often until the final date of
maturity
 Zero-coupon bonds – only pay back at final date of
maturity
9
FV=$FaceValue
$c $c $c $c … $c
Coupon ($c) paid out each period
FV=$100
$1 $1
2-period (e.g. 2 year) bond

Coupon ($1) paid out each period
$1 $1
10
Macro Fundamentals
BOND MARKETS
 Simplify by supposing that all bonds are one-
period zero-coupon government bonds – i.e.,
short-term bonds
 Traditional simplification for analysis of monetary policy
 Understanding how short-term bond is priced
 Key to understanding how all bonds are priced
 Key to understanding how all sorts of financial
assets are priced
11
FV=$100
1-period bond
No coupon
Let’s normalize this FV to 1
(market will decide) 𝑷𝑷𝒃𝒃 FV= 1
?
How much are investors willing to pay for the “promise”/bond?
Investing 𝑷𝑷𝒃𝒃 𝟏𝟏
This means:
= 𝟏𝟏 + 𝒊𝒊
Getting back 1 𝑷𝑷𝒃𝒃
12
Macro Fundamentals
BOND MARKETS
 Key relationship between price of a bond and
nominal interest rate
FVt +1 1 1
b
Pt = b
Pt = it
= −1
1 + it 1 + it Pt b
Simplify and assume FV = 1 (will

get main ideas across)
 Notation
 Pbt: nominal price of a one-period bond
 it: nominal interest rate between period t and period
t+1
 FVt+1: face-value of bond (i.e., how much will be repaid
in t+1)
In reality, many different values of FV ($100, $1000,
$10,000,etc…) 13
Return Return
FV
𝑃𝑃𝑏𝑏
𝑃𝑃𝑏𝑏
Higher 𝑃𝑃𝑏𝑏 → lower return → lower 𝑖𝑖
Lower 𝑃𝑃𝑏𝑏 → higher return → higher 𝑖𝑖

14
Macro Fundamentals
BOND MARKETS
 Inverse relationship between price of a
bond and nominal interest rate – critical
 Short-term bond markets are/have been

the conventional channel through which
Federal Reserve conducts monetary policy
15
Extra/Not tested
Federal Reserve
• Manage the money supply through open
market operations
• Buy back bonds from the US largest security
dealers and banks (primary dealers), not with
the general public.
• Upon buying back the bonds, Fed in return
gives money to banks.
16
Extra/Not tested
Banks
• Required to keep some % of the deposit as
reserves. The rest can be lent to the general
public
• So upon selling the bonds to Fed, the banks

will have extra money (which can be lent to
general public). This will start the multiplier
effect of money, causing the money supply to
increase.
17
Extra/Not tested
Money
Banks
Government
Issue Bonds
To borrow for
Government Spending
18
Extra/Not tested
Reserve ratio = 10%
FED
90
Banks
72.9
81 90 100
81
72.9
19
Extra/Not tested
From $100 released from Fed, the money

supply will increase by:
$100 + $90 + $81 + $72.9 + …

=
$100 + $100 × 0.9 + $100 × 0.92 + $100 × 0.93 + ⋯
=
$𝟏𝟏𝟏𝟏𝟏𝟏 {1 + 0.9 +0.92 +0.93 + ⋯ }
1 $100
= $100
1 − 0.9
=
0.1 = $1000
∆𝑀𝑀 𝑆𝑆 20
Conventional Monetary Policy

 Short-term bond markets and money markets
tightly linked to each other
CRUCIAL LINK
Pb = 1/(1+i)
21

 i can be thought of in two (mirror-image)
ways
 The interest payoff of a bond
 Opportunity cost of holding money
 Each unit of wealth held as a dollar is a unit of
wealth not held as a bond, which entails the loss of
chance to earn interest (i.e., opportunity cost)
 i is interpreted as “the price of money”
 Conventional monetary policy

 Intro macro: Fed open-market operations
conducted via short-term bond markets, so
Fed operations do affect bond supply
22

 Intro macro: open-market operations conducted
via short-term bond markets
CRUCIAL LINK
Pb = 1/(1+i)
23

24

 Expansionary monetary policy by Fed
 Fed buys short bonds from financial sector,

reducing open-market supply…
 …by printing new money, increasing supply in

money market…
 …which causes short-term i to decrease
25

26
 Contractionary monetary policy by Fed
 Fed sells short bonds to financial sector,

increasing open-market supply …
 …in exchange for money, decreasing supply in

money market…
 …which causes short-term i to increase
27
MONETARY POLICY IN THE
INFINITE-PERIOD ANALYSIS
CHAPTER 15
KEYS
• Construct the real money demand curve
• Discuss the impact of monetary policy

using the demand curve
Introduction
BASICS
 Extend our infinite-period framework
 Introduce money and short-term bonds into the
Chapter 8 framework
 So now three types of assets (stocks, short-term
bonds, money) for representative consumer to use for
savings purposes
 Will allow us to think further about what the

“pricing kernel” is
 Will allow us to understand connection between

bond prices and stock prices
30
Introduction
BASICS
 Will allow us to consider monetary neutrality (the
main issue in the RBC vs. New Keynesian debate)
 i.e., does money (and thus monetary policy) have
important consequences for real (i.e., consumption and
real GDP) variables?
 Index time periods by arbitrary indexes t, t+1,

t+2, etc.
 Important: all of our analysis will be conducted from
the perspective of the very beginning of period t…
 Sequential Lagrangian analysis (with money in

the utility function)
31
Introduction
MIU FUNCTION
 Individuals obtain utility from purchasing power
of money
 Medium of exchange
 Unit of account
 Store of value
 Thus DEMAND holdings of nominal money
 M  D
u  ct , t

 Pt 
32
Introduction
MIU FUNCTION
 In consumer optimization problem, it’s MD
everywhere
 MS is determined by the central bank
 In money market equilibrium
D S
Mt M M
= = t t
Pt Pt Pt
33
Introduction
BASICS
 Timeline of events
at-1 Economic events during at Economic events during at+1 Economic events during at+2
period t: income, period t+1: income, period t+2: income,
consumption, savings consumption, savings consumption, savings
Period t Period t+1 Period t+2
 Notation
 ct: consumption in period t
 Pt: nominal price of consumption in period t
 Yt: nominal income in period t (“falls from the sky”)
 at-1: real stock holdings at beginning of period t/end of
period t-1 34
Introduction
BASICS
at-1 at at+1 at+2
Bt-1 Bt Bt+1 Bt+2
Economic events during Economic events during Economic events during
Mt-1 Mt Mt+1 Mt+2
 Notation
 ct: consumption in period t
 Pt: nominal price of consumption in period t
 Yt: nominal income in period t (“falls from the sky”)
Now three
types of  at-1: real stock holdings at beginning of period t/end of period t-1
assets
consumers
 Mt-1: nominal money holdings at beginning of period t/end of period t-1
can use for  Bt-1: nominal bond holdings at beginning of period t/end of period t-1
savings 35
purposes
Introduction
BASICS
 …
 …. …
 ….
 𝑆𝑆𝑡𝑡: nominal price of a unit of stock in period t
 𝐷𝐷𝑡𝑡: nominal dividend paid in period t by each unit of stock
held at the start of t
 𝑃𝑃𝑏𝑏𝑡𝑡: nominal price of a bond in period t
 it: nominal interest rate on a bond purchased in t and
which pays off in t+1
 𝑖𝑖𝑡𝑡: nominal interest rate on a bond purchased in t and
 𝜋𝜋𝑡𝑡 + 1: net inflation rate between period t and period t+1
 𝑦𝑦𝑡𝑡: real income in period t ( = Yt/Pt)
36
Introduction
BASICS
 ….
 Notation
 ct+1: consumption in period t+1 …
 Pt+1: nominal price of consumption in period t+1
 Yt+1: nominal income in period t+1 (“falls from the sky”)
 at: real stock holdings at beginning of period t+1/end of
period t
 Mt: nominal money holdings at beginning of period t+1/end
of period t
 Bt: nominal bond holdings at beginning of period t+1/end
of period t
37
Introduction
BASICS
 ….
 Notation
 … …
 St+1: nominal price of a unit of stock in period t+1

 Dt+1: nominal dividend paid in t+1 by each unit of stock held
at the start of t+1
 Pbt+1: nominal price of a bond in period t+1
 it+1: nominal interest rate on a bond purchased in t+1 and
 𝜋𝜋𝑡𝑡 + 2: net inflation rate between period t+1 and period t+2
 yt+1: real income in period t ( = Yt+1/Pt+1)
38
Introduction
BASICS
at-1 at at+1 at+2

Bt-1 Bt Bt+1 Bt+2
Economic events during Economic events during Economic events during
Mt-1 Mt Mt+1 Mt+2
 Notation
 And so on for period t+2, t+3, etc…
39
Model Structure
BUDGET CONSTRAINT(S)
 Extend budget constraints from Chapter 8
stock-pricing framework to now include three
distinct types of assets: stocks, money, and
short-term bonds
 Need infinite budget constraints to describe

economic opportunities and possibilities
 One for each period
40
𝑃𝑃𝑡𝑡 𝑐𝑐𝑡𝑡 +𝑃𝑃𝑡𝑡𝑏𝑏 𝐵𝐵𝑡𝑡 +𝑀𝑀𝑡𝑡 +𝑆𝑆𝑡𝑡 𝑎𝑎𝑡𝑡
= 𝑌𝑌𝑡𝑡 +𝑀𝑀𝑡𝑡−1 + 𝟏𝟏 ⋅ 𝐵𝐵𝑡𝑡−1 + 𝑆𝑆𝑡𝑡 𝑎𝑎𝑡𝑡−1+ 𝐷𝐷𝑡𝑡 𝑎𝑎𝑡𝑡−1
New bonds ∆𝑀𝑀 𝑆𝑆𝑡𝑡 ∆𝑎𝑎𝑡𝑡
𝑃𝑃𝑡𝑡 𝑐𝑐𝑡𝑡 +𝑃𝑃𝑡𝑡𝑏𝑏 𝐵𝐵𝑡𝑡 +𝑀𝑀𝑡𝑡 − 𝑀𝑀𝑡𝑡−1 +𝑆𝑆𝑡𝑡 𝑎𝑎𝑡𝑡 − 𝑆𝑆𝑡𝑡 𝑎𝑎𝑡𝑡−1
= 𝑌𝑌𝑡𝑡 + 𝟏𝟏 ⋅ 𝐵𝐵𝑡𝑡−1 + 𝐷𝐷𝑡𝑡 𝑎𝑎𝑡𝑡−1
41
Model Structure
 …
 …
 …
 In period t
b
Pc
t t + Pt Bt + M t + St a=
t Yt + M t −1 + Bt −1 + St at −1 + Dt at −1
Total outlays in Total income in period t: period-t Y +
period t: period-t income from stock-holdings carried
consumption + into period t (has value St and pays
stocks to carry into dividend Dt) + money-holdings
period t+1 + carried into period t + bond-holdings
money to carry into carried into period t (each unit repays
period t+1 + bond FV = 1)
purchases
42
Model Structure
 In period t+1
b
Pt +1ct +1 + P B + M t +1 + St +1at +1 =Yt +1 + M t + Bt + St +1at + Dt +1at
t +1 t +1
Total outlays in period t+1: Total income in period t+1:

period-t+1 consumption + period-t+1 Y + income from
stocks to carry into period t+2 + stock-holdings carried into
money to carry into period t+2 + period t+1 (has value St+1 and
bond purchases pays dividend Dt+1) + money-
holdings carried into period t+1
+ bond-holdings carried into
period t+1 (each unit repays
FV = 1)
 And analogous budget constraints in period
t+2, t+3, t+4, etc. 43
Infinite-Period Model: Sequential Formulation
LAGRANGE ANALYSIS: SEQUENTIAL APPROACH

 Step 1: Construct Lagrange function (starting from t)
𝑴𝑴𝒕𝒕 𝑴𝑴𝒕𝒕+𝟏𝟏 𝑴𝑴𝒕𝒕+𝟐𝟐

𝑢𝑢 𝑐𝑐𝑡𝑡 , +𝛽𝛽𝛽𝛽 𝑐𝑐𝑡𝑡+1 , 2
+𝛽𝛽 𝑢𝑢 𝑐𝑐𝑡𝑡+2 , +⋯
𝑷𝑷𝒕𝒕 𝑷𝑷𝒕𝒕+𝟏𝟏 𝑷𝑷𝒕𝒕+𝟐𝟐
+𝜆𝜆𝑡𝑡 [𝑌𝑌𝑡𝑡 + 𝑆𝑆𝑡𝑡 + 𝐷𝐷𝑡𝑡 𝑎𝑎𝑡𝑡−1 + 𝑴𝑴𝒕𝒕−𝟏𝟏 + 𝐵𝐵𝑡𝑡−1 − 𝑃𝑃𝑡𝑡 𝑐𝑐𝑡𝑡 − 𝑆𝑆𝑡𝑡 𝑎𝑎𝑡𝑡 − 𝑴𝑴𝒕𝒕 − 𝑃𝑃𝑡𝑡𝑏𝑏 𝐵𝐵𝑡𝑡 ]
𝑏𝑏
+𝛽𝛽𝜆𝜆𝑡𝑡+1[𝑌𝑌𝑡𝑡+1 + 𝑆𝑆𝑡𝑡+1 +𝐷𝐷𝑡𝑡+1 𝑎𝑎𝑡𝑡 +𝑴𝑴𝒕𝒕 +𝐵𝐵𝑡𝑡 −𝑃𝑃𝑡𝑡+1𝑐𝑐𝑡𝑡+1 −𝑆𝑆𝑡𝑡+1𝑎𝑎𝑡𝑡+1 −𝑴𝑴𝒕𝒕+𝟏𝟏 −𝑃𝑃𝑡𝑡+1𝐵𝐵𝑡𝑡+1]
𝑏𝑏
+𝛽𝛽2𝜆𝜆𝑡𝑡+2[𝑌𝑌𝑡𝑡+2 + 𝑆𝑆𝑡𝑡+2 +𝐷𝐷𝑡𝑡+2 𝑎𝑎𝑡𝑡+1 +𝑴𝑴𝒕𝒕+𝟏𝟏 +𝐵𝐵𝑡𝑡+1 −𝑃𝑃𝑡𝑡+2𝑐𝑐𝑡𝑡+2 −𝑆𝑆𝑡𝑡+2𝑎𝑎𝑡𝑡+2 −𝑴𝑴𝒕𝒕+𝟐𝟐 −𝑃𝑃𝑡𝑡+2𝐵𝐵𝑡𝑡+2]
𝑏𝑏
+𝛽𝛽3𝜆𝜆𝑡𝑡+3[𝑌𝑌𝑡𝑡+3 + 𝑆𝑆𝑡𝑡+3 +𝐷𝐷𝑡𝑡+3 𝑎𝑎𝑡𝑡+2 +𝑴𝑴𝒕𝒕+𝟐𝟐 +𝐵𝐵𝑡𝑡+2 −𝑃𝑃𝑡𝑡+3𝑐𝑐𝑡𝑡+3 −𝑆𝑆𝑡𝑡+3𝑎𝑎𝑡𝑡+3 −𝑴𝑴𝒕𝒕+𝟑𝟑 −𝑃𝑃𝑡𝑡+3𝐵𝐵𝑡𝑡+3]
+⋯
𝑐𝑐𝑡𝑡 , 𝑐𝑐𝑡𝑡+1 , 𝑐𝑐𝑡𝑡+2 … ;

𝑎𝑎𝑡𝑡 , 𝑎𝑎𝑡𝑡+1 , 𝑎𝑎𝑡𝑡+2 , … ;
𝐿𝐿 𝑴𝑴𝒕𝒕 , 𝑴𝑴𝒕𝒕+𝟏𝟏 , 𝑴𝑴𝒕𝒕+𝟐𝟐 , … ;
𝐵𝐵𝑡𝑡 , 𝐵𝐵𝑡𝑡+1 , 𝐵𝐵𝑡𝑡+2 , … ;
𝜆𝜆𝑡𝑡 , 𝜆𝜆𝑡𝑡+1 , …
𝜕𝜕{ 𝑢𝑢 𝒄𝒄𝒕𝒕 ,
𝑀𝑀𝑡𝑡
𝑃𝑃𝑡𝑡 +𝛽𝛽𝛽𝛽 𝑐𝑐𝑡𝑡+1 ,
𝑀𝑀𝑡𝑡+1
𝑃𝑃𝑡𝑡+1
2
+𝛽𝛽 𝑢𝑢 𝑐𝑐𝑡𝑡+2 ,
𝑀𝑀𝑡𝑡+2
𝑃𝑃𝑡𝑡+2
+⋯
+𝜆𝜆𝑡𝑡 [𝑌𝑌𝑡𝑡 + 𝑆𝑆𝑡𝑡 + 𝐷𝐷𝑡𝑡 𝑎𝑎𝑡𝑡−1 + 𝑀𝑀𝑡𝑡−1 + 𝐵𝐵𝑡𝑡−1 − 𝑷𝑷𝒕𝒕 𝒄𝒄𝒕𝒕 − 𝑆𝑆𝑡𝑡 𝑎𝑎𝑡𝑡 − 𝑀𝑀𝑡𝑡 − 𝑃𝑃𝑡𝑡𝑏𝑏 𝐵𝐵𝑡𝑡 ]
𝑏𝑏
+𝛽𝛽𝜆𝜆𝑡𝑡+1[𝑌𝑌𝑡𝑡+1 + 𝑆𝑆𝑡𝑡+1 +𝐷𝐷𝑡𝑡+1 𝑎𝑎𝑡𝑡 +𝑀𝑀𝑡𝑡 +𝐵𝐵𝑡𝑡 −𝑃𝑃𝑡𝑡+1𝑐𝑐𝑡𝑡+1 −𝑆𝑆𝑡𝑡+1𝑎𝑎𝑡𝑡+1 −𝑀𝑀𝑡𝑡+1 −𝑃𝑃𝑡𝑡+1𝐵𝐵𝑡𝑡+1]
𝑏𝑏
+𝛽𝛽2𝜆𝜆𝑡𝑡+2[𝑌𝑌𝑡𝑡+2 + 𝑆𝑆𝑡𝑡+2 +𝐷𝐷𝑡𝑡+2 𝑎𝑎𝑡𝑡+1 +𝑀𝑀𝑡𝑡+1 +𝐵𝐵𝑡𝑡+1 −𝑃𝑃𝑡𝑡+2𝑐𝑐𝑡𝑡+2 −𝑆𝑆𝑡𝑡+2𝑎𝑎𝑡𝑡+2 −𝑀𝑀𝑡𝑡+2 −𝑃𝑃𝑡𝑡+2𝐵𝐵𝑡𝑡+2]
+⋯ }
𝜕𝜕𝒄𝒄𝒕𝒕
𝑀𝑀𝑡𝑡
𝑢𝑢1 𝑐𝑐𝑡𝑡 , − 𝜆𝜆𝑡𝑡 𝑃𝑃𝑡𝑡 = 0
𝑃𝑃𝑡𝑡
𝜕𝜕{ 𝑢𝑢 𝑐𝑐𝑡𝑡 ,
𝑀𝑀𝑡𝑡
𝑀𝑀𝑡𝑡+1
𝑃𝑃𝑡𝑡+1
2
𝑀𝑀𝑡𝑡+2
𝑃𝑃𝑡𝑡+2
+⋯
+𝜆𝜆𝑡𝑡 [𝑌𝑌𝑡𝑡 + 𝑆𝑆𝑡𝑡 + 𝐷𝐷𝑡𝑡 𝑎𝑎𝑡𝑡−1 + 𝑀𝑀𝑡𝑡−1 + 𝐵𝐵𝑡𝑡−1 − 𝑃𝑃𝑡𝑡 𝑐𝑐𝑡𝑡 − 𝑺𝑺𝒕𝒕 𝒂𝒂𝒕𝒕 − 𝑀𝑀𝑡𝑡 − 𝑃𝑃𝑡𝑡𝑏𝑏 𝐵𝐵𝑡𝑡 ]
𝑏𝑏
+𝛽𝛽𝜆𝜆𝑡𝑡+1[𝑌𝑌𝑡𝑡+1 + 𝑺𝑺𝒕𝒕+𝟏𝟏 +𝑫𝑫𝒕𝒕+𝟏𝟏 𝒂𝒂𝒕𝒕 +𝑀𝑀𝑡𝑡 +𝐵𝐵𝑡𝑡 −𝑃𝑃𝑡𝑡+1𝑐𝑐𝑡𝑡+1 −𝑆𝑆𝑡𝑡+1𝑎𝑎𝑡𝑡+1 −𝑀𝑀𝑡𝑡+1 −𝑃𝑃𝑡𝑡+1𝐵𝐵𝑡𝑡+1]
𝑏𝑏
+⋯ }
𝜕𝜕𝒂𝒂𝒕𝒕
−𝜆𝜆𝑡𝑡 𝑆𝑆𝑡𝑡 + 𝛽𝛽𝜆𝜆𝑡𝑡+1 𝑆𝑆𝑡𝑡+1 + 𝐷𝐷𝑡𝑡+1 = 0

𝑀𝑀𝑡𝑡
𝑀𝑀𝑡𝑡+1
𝑃𝑃𝑡𝑡+1
2
𝑀𝑀𝑡𝑡+2
𝑃𝑃𝑡𝑡+2
+⋯
+𝜆𝜆𝑡𝑡 [𝑌𝑌𝑡𝑡 + 𝑆𝑆𝑡𝑡 + 𝐷𝐷𝑡𝑡 𝑎𝑎𝑡𝑡−1 + 𝑀𝑀𝑡𝑡−1 + 𝐵𝐵𝑡𝑡−1 − 𝑃𝑃𝑡𝑡 𝑐𝑐𝑡𝑡 − 𝑆𝑆𝑡𝑡 𝑎𝑎𝑡𝑡 − 𝑀𝑀𝑡𝑡 − 𝑷𝑷𝒃𝒃𝒕𝒕 𝑩𝑩𝒕𝒕 ]
𝑏𝑏
+𝛽𝛽𝜆𝜆𝑡𝑡+1[𝑌𝑌𝑡𝑡+1 + 𝑆𝑆𝑡𝑡+1 +𝐷𝐷𝑡𝑡+1 𝑎𝑎𝑡𝑡 +𝑀𝑀𝑡𝑡 +𝑩𝑩𝒕𝒕 −𝑃𝑃𝑡𝑡+1𝑐𝑐𝑡𝑡+1 −𝑆𝑆𝑡𝑡+1𝑎𝑎𝑡𝑡+1 −𝑀𝑀𝑡𝑡+1 −𝑃𝑃𝑡𝑡+1𝐵𝐵𝑡𝑡+1]
𝑏𝑏
+⋯ }
𝜕𝜕𝑩𝑩𝒕𝒕
−𝝀𝝀𝒕𝒕 𝑷𝑷𝒃𝒃𝒕𝒕 + 𝜷𝜷𝝀𝝀𝒕𝒕+𝟏𝟏 = 𝟎𝟎

𝑴𝑴𝒕𝒕
𝑷𝑷𝒕𝒕 +𝛽𝛽𝛽𝛽 𝑐𝑐𝑡𝑡+1 ,
𝑀𝑀𝑡𝑡+1
𝑃𝑃𝑡𝑡+1
2
𝑀𝑀𝑡𝑡+2
𝑃𝑃𝑡𝑡+2
+⋯
+𝜆𝜆𝑡𝑡 [𝑌𝑌𝑡𝑡 + 𝑆𝑆𝑡𝑡 + 𝐷𝐷𝑡𝑡 𝑎𝑎𝑡𝑡−1 + 𝑀𝑀𝑡𝑡−1 + 𝐵𝐵𝑡𝑡−1 − 𝑃𝑃𝑡𝑡 𝑐𝑐𝑡𝑡 − 𝑆𝑆𝑡𝑡 𝑎𝑎𝑡𝑡 − 𝑴𝑴𝒕𝒕 − 𝑃𝑃𝑡𝑡𝑏𝑏 𝐵𝐵𝑡𝑡 ]
𝑏𝑏
+𝛽𝛽𝜆𝜆𝑡𝑡+1[𝑌𝑌𝑡𝑡+1 + 𝑆𝑆𝑡𝑡+1 +𝐷𝐷𝑡𝑡+1 𝑎𝑎𝑡𝑡 +𝑴𝑴𝒕𝒕 +𝐵𝐵𝑡𝑡 −𝑃𝑃𝑡𝑡+1𝑐𝑐𝑡𝑡+1 −𝑆𝑆𝑡𝑡+1𝑎𝑎𝑡𝑡+1 −𝑀𝑀𝑡𝑡+1 −𝑃𝑃𝑡𝑡+1𝐵𝐵𝑡𝑡+1]
𝑏𝑏
+⋯ }
𝜕𝜕𝑴𝑴𝒕𝒕
𝑀𝑀𝑡𝑡
𝜕𝜕𝜕𝜕 𝑐𝑐𝑡𝑡 ,
𝑃𝑃𝑡𝑡
− 𝜆𝜆𝑡𝑡 + 𝛽𝛽𝜆𝜆𝑡𝑡+1 = 0
𝜕𝜕𝑀𝑀𝑡𝑡
𝑀𝑀𝑡𝑡
𝜕𝜕𝜕𝜕 𝑐𝑐𝑡𝑡 ,
𝑃𝑃𝑡𝑡
− 𝜆𝜆𝑡𝑡 + 𝛽𝛽𝜆𝜆𝑡𝑡+1 = 0
𝜕𝜕𝑀𝑀𝑡𝑡
𝑀𝑀𝑡𝑡 𝑴𝑴𝒕𝒕
𝜕𝜕𝜕𝜕 𝑐𝑐𝑡𝑡 , 𝝏𝝏
⟹ 𝑃𝑃𝑡𝑡 𝑷𝑷𝒕𝒕
⋅ − 𝜆𝜆𝑡𝑡 + 𝛽𝛽𝜆𝜆𝑡𝑡+1 = 0
𝑴𝑴𝒕𝒕 𝜕𝜕𝑀𝑀𝑡𝑡
𝝏𝝏
𝑷𝑷𝒕𝒕
𝑀𝑀𝑡𝑡 𝟏𝟏
⟹ 𝑢𝑢2 𝑐𝑐𝑡𝑡 , ⋅ − 𝜆𝜆𝑡𝑡 + 𝛽𝛽𝜆𝜆𝑡𝑡+1 = 0
𝑃𝑃𝑡𝑡 𝑷𝑷𝒕𝒕

 Step 2: Compute FOCs with respect to ct,
at, Bt, Mt, …
𝑀𝑀𝑡𝑡
with respect to ct: 𝑢𝑢1 𝑐𝑐𝑡𝑡 , − 𝜆𝜆𝑡𝑡 𝑃𝑃𝑡𝑡 = 0
𝑃𝑃𝑡𝑡
with respect to at: −𝜆𝜆𝑡𝑡 𝑆𝑆𝑡𝑡 + 𝛽𝛽𝜆𝜆𝑡𝑡+1 𝑆𝑆𝑡𝑡+1 + 𝐷𝐷𝑡𝑡+1 = 0
with respect to Bt: −𝜆𝜆𝑡𝑡 𝑃𝑃𝑡𝑡𝑏𝑏 + 𝛽𝛽𝜆𝜆𝑡𝑡+1 = 0
𝑀𝑀𝑡𝑡 1
with respect to Mt: 𝑢𝑢2 𝑐𝑐𝑡𝑡 , ⋅ − 𝜆𝜆𝑡𝑡 + 𝛽𝛽𝜆𝜆𝑡𝑡+1 = 0
𝑃𝑃𝑡𝑡 𝑃𝑃𝑡𝑡
51
Finance Fundamentals
ASSET PRICING REVISITED
−𝜆𝜆𝑡𝑡 𝑆𝑆𝑡𝑡 + 𝛽𝛽𝜆𝜆𝑡𝑡+1 𝑆𝑆𝑡𝑡+1 + 𝐷𝐷𝑡𝑡+1 = 0
 Equation 2 
STOCK-PRICING EQUATION
 βλt +1 
St =   ( St +1 + Dt +1 )
 λt 
Period-t Pricing Future
stock price = x
return
kernel
52

 Much of finance theory concerned with pricing
kernel
 Theoretical properties
 Empirical models of kernels
 Pricing kernel where macro theory and finance

theory intersect
 Lagrange multipliers where macro and finance intersect
– an idea that will be important in financial accelerator
framework
53
−𝜆𝜆𝑡𝑡 𝑃𝑃𝑡𝑡𝑏𝑏 + 𝛽𝛽𝜆𝜆𝑡𝑡+1 = 0 Equation 3
 Equation 2   βλt +1 
St =   ( St +1 + Dt +1 )
 λt  STOCK-PRICING EQUATION
b βλt +1
 Equation 3 
Pt = BOND-PRICING EQUATION
λt
54
 Price of short-term bond is the pricing

kernel
 Stock prices and bond prices are connected
 Most (all?) asset prices fundamentally
connected to bond prices
Terminology:
 Finance: pricing kernel reflects the “riskless” asset
price/return of the least risky asset in the
economy – U.S. Treasury short-term bonds
55
Equation 3  bβλt +1

Pt = BOND-PRICING EQUATION
λt
b 1
 Recall Pt =
1 + it
  can express pricing kernel as
βλt +1 1
=
λt 1 + it 56
Money Demand
CONSUMPTION-MONEY OPTIMALITY CONDITION

Begin with equation 4:
𝑀𝑀𝑡𝑡
𝑢𝑢2 𝑐𝑐𝑡𝑡 ,
𝑃𝑃𝑡𝑡
− 𝜆𝜆𝑡𝑡 = −𝜷𝜷𝝀𝝀𝒕𝒕+𝟏𝟏
𝑃𝑃𝑡𝑡
Use βλt+1 = λtPbt from equation 3
𝑀𝑀𝑡𝑡
𝑃𝑃𝑡𝑡
− 𝜆𝜆𝑡𝑡 = −𝜆𝜆𝑡𝑡 𝑃𝑃𝑡𝑡𝑏𝑏
𝑃𝑃𝑡𝑡
Divide through by λt
𝑀𝑀𝑡𝑡
𝑃𝑃𝑡𝑡
− 1 = −𝑃𝑃𝑡𝑡𝑏𝑏
𝜆𝜆𝑡𝑡 𝑃𝑃𝑡𝑡
57
Money Demand

Begin with
equation 4: 𝑀𝑀𝑡𝑡
𝑃𝑃𝑡𝑡
− 1 = −𝑃𝑃𝑡𝑡𝑏𝑏
𝝀𝝀𝒕𝒕 𝑷𝑷𝒕𝒕
𝑴𝑴𝒕𝒕
Use 𝒖𝒖𝟏𝟏 𝒄𝒄𝒕𝒕 , = 𝝀𝝀𝒕𝒕 𝑷𝑷𝒕𝒕 from equation 1
𝑷𝑷𝒕𝒕
𝑀𝑀𝑡𝑡
𝑃𝑃𝑡𝑡
− 1 = −𝑷𝑷𝒃𝒃𝒕𝒕
𝑴𝑴
𝒖𝒖𝟏𝟏 𝒄𝒄𝒕𝒕 , 𝒕𝒕
𝑷𝑷𝒕𝒕
Use P
b
t = 1/(1+it)
𝑢𝑢2 … 𝟏𝟏
−1=−
𝒖𝒖𝟏𝟏 … 𝟏𝟏 + 𝒊𝒊𝒕𝒕
58
Money Demand
𝑀𝑀𝑡𝑡
𝑢𝑢2 𝑐𝑐𝑡𝑡 , 𝟏𝟏
𝑃𝑃𝑡𝑡
−1=−
𝑴𝑴 𝟏𝟏 + 𝒊𝒊𝒕𝒕
𝑷𝑷𝒕𝒕
𝑀𝑀𝑡𝑡
𝑢𝑢2 𝑐𝑐𝑡𝑡 , 𝟏𝟏
𝑃𝑃𝑡𝑡
=− + 𝟏𝟏
𝑷𝑷𝒕𝒕
𝑀𝑀𝑡𝑡
𝑢𝑢2 𝑐𝑐𝑡𝑡 , 𝒊𝒊𝒕𝒕
𝑃𝑃𝑡𝑡
=
CONSUMPTION-MONEY
OPTIMALITY CONDITION
𝑷𝑷𝒕𝒕 59
Money Demand
MONEY DEMAND
 Consumption-money optimality condition
the foundation of money demand function
 Example: suppose
 Mt   Mt 
u  ct , =  ln ct + ln  
 Pt   Pt 
 Mt  1  Mt  1
 Thus, u1  ct , = and u2  ct , =
 Pt  ct  Pt  M t / Pt
𝑀𝑀𝑡𝑡
𝜕𝜕𝜕𝜕 𝑐𝑐𝑡𝑡 ,
𝑃𝑃𝑡𝑡
𝑴𝑴𝒕𝒕
𝝏𝝏 60
𝑷𝑷𝒕𝒕
Money Demand
MONEY DEMAND
 Consumption-money optimality condition (for this
utility function…) is
REAL MONEY
Pc it DEMAND
t t
= FUNCTION:
M t 1 + it depends positively
on ct and
Isolate the Mt/Pt term negatively on it (it
is the opportunity
Mt  1 + it  cost of money)
= ct ⋅  
Pt  it 
 Use this money demand function to analyze
 The monetary neutrality debate
 The long-run (aka steady-state) connection between
monetary policy and inflation
61
INFINITE-PERIOD ECONOMY:
SHORT-RUN EFFECTS
Monetary Policy Analysis: Short-Run Effects
IS MONETARY POLICY NEUTRAL?

 An enduring question in macroeconomics:
does monetary policy have any important
effects on the real (i.e, real GDP,
consumption, etc) economy?
 Definition: Money (and hence monetary

policy) is neutral if changes in the money
supply (i.e., changes in monetary policy) have
no effect on the real economy
 Monetary policy is non-neutral if it does have

effects on the real economy
IS MONETARY POLICY NEUTRAL?

 New Keynesian view: money is non-neutral
(because prices are rigid/sticky, often for long
periods of time)
 RBC view: money is neutral (because prices are

not rigid/sticky in any important way)
 MIU framework allows us to consider how/why

monetary policy is or is not neutral
MONEY DEMAND
CONSUMPTION- u2 (ct , M t / Pt ) it
MONEY =
OPTIMALITY u1 (ct , M t / Pt ) 1 + it
CONDITION
MRS price ratio
Using utility function,

NOTE:
 Mt   Mt 
consumption-money u  ct , =  ln ct + ln  
optimality condition  Pt  P
 t 
and money demand
function are the
same thing, just
viewed from Mt  1 + it 
different points of
= ct ⋅  
view Pt  it 
MONEY DEMAND
 Use money demand function to illustrate effects

of money (monetary policy) shocks
 Gets at core of neutrality debate
 Let’s be even more precise about the timing of

events…
MONETARY NEUTRALITY DEBATE

 Precise timing of events within period t
Fed comes along and

determines actual Mt of Following money shock, the
Consumers make
economy – if different period-t consumption-money
optimal choices:
at-1 from planned Mt, a optimality condition must still at
in particular, of ct
“money shock” has hold. Question: what adjusts
Bt-1 and “planned Mt” Bt
occurred during period t to ensure it holds?
Mt-1 (actual) Mt
Period t

Fed comes along and

Consumers make
optimal choices:
Mt-1 (actual) Mt
Period t

Fed comes along and

Consumers make
optimal choices:
Mt-1 (actual) Mt
Period t

 Fed sets MSt after consumers make their
choices of ct and MDt (and other choices,
too…)
 If supply MSt differs from demanded MDt,
money shock has occurred
 Question: which adjusts (Pt or ct) to ensure

consumption-money optimality condition
holds? (simplify by assuming it doesn’t adjust)
This is a question Mt  1 + it 
about = ct ⋅  
EQUILIBRIUM,
with MS = MD Pt  it 

 Keynesian/New Keynesian view
Mt  1 + it 
 Pt cannot adjust because prices = ct ⋅  
Pt i
 t 
are sticky
 (Prices will adjust later (i.e, in period
t+1 or later), just not in period t)
 A positive (negative) money shock

leads to a rise (fall) in ct
 Money (and hence monetary
policy) is not neutral

Mt  1 + it 
= ct ⋅ 
 RBC view Pt i
 t 

 Pt can adjust because prices are not sticky

 No reason for ct to adjust (they do reflect
optimal choices, after all...)
 A positive (negative) money shock leads to no
change (no change) in ct
 Money (and hence monetary policy) is neutral
 Empirical evidence for “how sticky” are

prices is very mixed…
MONETARY NEUTRALITY DEBATE: EXAMPLE

Mt  1 + it 
= ct ⋅  
Pt i
 t 
 Assume it = 0.125 is fixed
 Consumers’ “demanded” choices are ct = 2 and

MDt = 180
 This plan was made with Pt = 10 in mind
 Fed sets actual MSt = 270 (a positive money

shock because actual MSt greater than demanded
MDt)

 Keynesian/New Keynesian view
 Pt = 10 won’t change (sticky prices)
 ct will rise (to ct = 3) to make

consumption-money
optimality condition hold
 Monetary policy is non-neutral
Mt  1 + it 
= ct ⋅  
Pt  it 
𝑀𝑀 𝑆𝑆 (𝐹𝐹𝐹𝐹𝐹𝐹)
i
𝑐𝑐 ↑
𝑖𝑖
𝑀𝑀𝐷𝐷′
𝑀𝑀𝐷𝐷
180 270 𝑀𝑀𝐷𝐷 , 𝑀𝑀 𝑆𝑆


Mt  1 + it 
= ct ⋅  
Pt i
 t 
 RBC view
 Consumers’ plan of ct = 2 is what the
economy really wants
 Pt can fully and quickly adjust to
accommodate this  Pt = 15
 Monetary policy is neutral; only effect of
monetary policy is on inflation
𝑀𝑀 𝑆𝑆 (𝐹𝐹𝐹𝐹𝐹𝐹)
i
𝑃𝑃 ↑
𝑖𝑖
𝑀𝑀𝐷𝐷′
𝑀𝑀𝐷𝐷
180 270 𝑀𝑀𝐷𝐷 , 𝑀𝑀 𝑆𝑆


Expansionary monetary
policy shifts AD
AS (if prices “very

sticky” in adjusting)
policy shifts AD

AS (if prices adjust “instantly”)
The crucial
issue: how
quickly do
nominal prices
adjust?

policy shifts AD

AS (if prices adjust “instantly”)
The crucial
issue: how
quickly do
nominal prices
adjust?

policy shifts AD
INFINITE-PERIOD ECONOMY:
LONG-RUN EFFECTS
Monetary Policy Analysis: Long-Run Effects
MONEY AND INFLATION IN THE LONG-RUN

 Question: what determines inflation in the long run (i.e.,
in steady-state)?
 Use both period-(t-1) and period-t money demand
functions to analyze
 Mt   Mt 
u  ct , =  ln ct + ln  
 Pt   Pt 
Money demand function in t-1 Money demand function in t
M t −1  1 + it −1  Mt  1 + it 
= ct −1 ⋅   = ct ⋅  
Pt −1  it −1  Pt  it 
Divide period t
money demand
by period t-1
M t / Pt ct  1 + it   it −1  money demand
= ⋅  
M t −1 / Pt −1 ct −1  it   1 + it −1 
M t / Pt ct  1 + it   it −1 
= ⋅  
M t −1 / Pt −1 ct −1  it   1 + it −1 
Recall definition And now define the money

of inflation growth rate in an analogous way:
Pt Mt
πt
= −1 µt
= −1
Pt −1 M t −1
1 + µt ct  1 + it   it −1 
= ⋅  
1 + π t ct −1  it   1 + it −1 
1 + µt ct  1 + it   it −1 
= ⋅  
1 + π t ct −1  it   1 + it −1 
Impose steady 𝒊𝒊. 𝒆𝒆. , 𝒄𝒄𝒕𝒕−𝟏𝟏 = 𝒄𝒄𝒕𝒕 = 𝒄𝒄, 𝒊𝒊𝒕𝒕−𝟏𝟏 = 𝒊𝒊𝒕𝒕 = 𝒊𝒊,
state 𝝅𝝅𝒕𝒕 = 𝝅𝝅, 𝒂𝒂𝒂𝒂𝒂𝒂 𝝁𝝁𝒕𝒕 = 𝝁𝝁
1+ µ c  1+ i  i 
= ⋅  
1+ π c  i  1+ i 
This is LR perspective
taken by monetarist
µ =π IN LONG RUN, RATE
OF MONEY GROWTH
= RATE OF
INFLATION
Monetary Policy Analysis: Money and Inflation
MONETARISM
µ =π IN LONG RUN, RATE OF MONEY
GROWTH = RATE OF INFLATION
 In steady state, inflation determined solely by

how quickly central bank (Fed) expands (or
shrinks) the nominal money supply
 This relationship the basis for the monetarist

school of thought
 Milton Friedman’s famous dictum: “Inflation is always
and everywhere a monetary phenomenon”
 Policy translation: “A central bank should not worry
about/try to control anything other than how quickly the
money supply in the economy is growing. Keeping
money growth under control will keep inflation under
control.”
Monetary Policy Analysis: Money and Inflation
MONETARISM
 …
 Rose to prominence in mid- and late 1970’s

(during macro crises)
 Largest policy influence in U.K., short-lived
policy influence in U.S.
 Largely died out as basis for serious policy
advice by mid-1980’s
 Nevertheless still viewed as fundamental “law” of

macroeconomics
 A concern today: Fed’s “easy monetary policy” (read:
Fed has increased money supply very rapidly) will lead
to a burst of inflation
Monetary Policy: Wrapup
MONETARY POLICY
 In short-run, do changes in monetary
policy have effects on consumption and
real GDP (in conventional conditions)?
 Keynesian/New Keynesian view: yes because
prices are sticky
 RBC view: no because prices are not sticky
 In long-run, changes in money growth

rate
 Have effects on only inflation
 Have no effects on consumption and real GDP
Monetary Policy: Wrapup
MONETARY POLICY
 Competing principles/theories influence
policy-makers’ decisions
 Basic models are guideposts for policy
debates
 Actual policy-making quite messy
 Requires lot of judgment
 Requires hope/belief that basic models are at

least somewhat useful guides to thinking

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MONEY AND BONDS

THE ROLES OF MONEY

THE ROLES OF MONEY

 Much more difficult than, i.e., “consumption-

 How to formally (mathematically) represent

THE ROLES OF MONEY

REAL MONEY BALANCES

 Unit Analysis (i.e., analyze algebraic units of

REAL MONEY BALANCES

 Measures the purchasing power of (nominal) money

 Mt and Pt can potentially grow at different rates

 In which case real money balances change from one

MONEY MARKETS AND BOND MARKETS

 Bond markets and money markets tightly

MONEY MARKETS AND BOND MARKETS

MONEY MARKETS AND BOND MARKETS

Coupon ($c) paid out each period

2-period (e.g. 2 year) bond

Let’s normalize this FV to 1

(market will decide) 𝑷𝑷𝒃𝒃 FV= 1

Simplify and assume FV = 1 (will

Higher 𝑃𝑃𝑏𝑏 → lower return → lower 𝑖𝑖

Lower 𝑃𝑃𝑏𝑏 → higher return → higher 𝑖𝑖

 Short-term bond markets are/have been

• So upon selling the bonds to Fed, the banks

Reserve ratio = 10%

From $100 released from Fed, the money

$100 + $90 + $81 + $72.9 + …

MONEY MARKETS AND BOND MARKETS

MONEY MARKETS AND BOND MARKETS

 Conventional monetary policy

MONEY MARKETS AND BOND MARKETS

MONEY MARKETS AND BOND MARKETS

MONEY MARKETS AND BOND MARKETS

 Fed buys short bonds from financial sector,

 …by printing new money, increasing supply in

 …which causes short-term i to decrease

MONEY MARKETS AND BOND MARKETS

MONEY MARKETS AND BOND MARKETS

 Contractionary monetary policy by Fed

 Fed sells short bonds to financial sector,

 …in exchange for money, decreasing supply in

 …which causes short-term i to increase

• Construct the real money demand curve

• Discuss the impact of monetary policy

 Will allow us to think further about what the

 Will allow us to understand connection between

 Index time periods by arbitrary indexes t, t+1,

 Sequential Lagrangian analysis (with money in

 Thus DEMAND holdings of nominal money

 In money market equilibrium

Period t Period t+1 Period t+2

Period t Period t+1 Period t+2

 St+1: nominal price of a unit of stock in period t+1

at-1 at at+1 at+2

Period t Period t+1 Period t+2

 Need infinite budget constraints to describe

= 𝑌𝑌𝑡𝑡 +𝑀𝑀𝑡𝑡−1 + 𝟏𝟏 ⋅ 𝐵𝐵𝑡𝑡−1 + 𝑆𝑆𝑡𝑡 𝑎𝑎𝑡𝑡−1+ 𝐷𝐷𝑡𝑡 𝑎𝑎𝑡𝑡−1

New bonds ∆𝑀𝑀 𝑆𝑆𝑡𝑡 ∆𝑎𝑎𝑡𝑡

= 𝑌𝑌𝑡𝑡 + 𝟏𝟏 ⋅ 𝐵𝐵𝑡𝑡−1 + 𝐷𝐷𝑡𝑡 𝑎𝑎𝑡𝑡−1

Total outlays in period t+1: Total income in period t+1:

LAGRANGE ANALYSIS: SEQUENTIAL APPROACH

𝑴𝑴𝒕𝒕 𝑴𝑴𝒕𝒕+𝟏𝟏 𝑴𝑴𝒕𝒕+𝟐𝟐